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ISSN 1045-6333 HARVARD - CompensationStandards.com

issn 1045-6333 HARVARD JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS PUTTING EXECUTIVE PENSIONS ON THE RADAR SCREEN Lucian Bebchuk and Robert J. Jackson, Jr. Discussion Paper No. 507 03/2005, Revised 04/2005 HARVARD Law School Cambridge, MA 02138 This paper can be downloaded free of charge from: The HARVARD John M. Olin Discussion Paper Series: The Social Science Research Network Electronic Paper Collection: This paper is also a discussion paper of the John M. Olin Center's Program on Corporate Governance Putting Executive Pensions on the Radar Screen Lucian Arye Bebchuk* and Robert J. Jackson, Jr. ** * William J. Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance, HARVARD Law School; Research Associate, National Bureau of Economic Research.

ISSN 1045-6333 HARVARD JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS PUTTING EXECUTIVE PENSIONS ON THE RADAR SCREEN Lucian Bebchuk and Robert J. Jackson, Jr. Discussion Paper No. 507 03/2005, Revised 04/2005

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Transcription of ISSN 1045-6333 HARVARD - CompensationStandards.com

1 issn 1045-6333 HARVARD JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS PUTTING EXECUTIVE PENSIONS ON THE RADAR SCREEN Lucian Bebchuk and Robert J. Jackson, Jr. Discussion Paper No. 507 03/2005, Revised 04/2005 HARVARD Law School Cambridge, MA 02138 This paper can be downloaded free of charge from: The HARVARD John M. Olin Discussion Paper Series: The Social Science Research Network Electronic Paper Collection: This paper is also a discussion paper of the John M. Olin Center's Program on Corporate Governance Putting Executive Pensions on the Radar Screen Lucian Arye Bebchuk* and Robert J. Jackson, Jr. ** * William J. Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance, HARVARD Law School; Research Associate, National Bureau of Economic Research.

2 ** Olin Fellow in Law and Economics, HARVARD Law School. We benefited from conversations with Joseph Bachelder, Eric Dash, Brian Foley, and Jesse Fried. For financial support, we are grateful to the John M. Olin Center for Law, Economics, and Business, the Guggenheim Foundation, the Nathan Cummins Foundation, and the Lens Foundation for Corporate Excellence. Lucian Bebchuk and Robert Jackson 2005. All rights reserved. Abstract Because public firms are not required to disclose the monetary value of pension plans in their executive pay disclosures, financial economists and the media alike have generally analyzed executive pay using figures that do not include the value of such pension plans. This paper presents evidence that omitting the value of pension benefits significantly undermines the accuracy of existing estimates of executive pay, its variability, and its sensitivity to performance.

3 We study the pension arrangements of CEOs of S&P 500 companies that (1) are now serving and are near the retirement age; or (2) left their positions during 2003 and the first half of 2004. Roughly two-thirds of these CEO have a pension plan (or similar retirement arrangement), and our findings with respect to these CEOs are as follows: The executives pension plans had a median actuarial value of $15 million. The ratio of the executives pension value to the executives total compensation (including both equity and non-equity pay) during their service as CEO had a median value of 34%. Including pension values increased the median percentage of the executives total compensation composed of salary-like payments during and after their service as CEO from 15% to 39%.

4 In addition, the pension benefits in our sample varied considerably with respect to both their magnitude and their relationship to the executives overall compensation. Our findings indicate that the standard omission of pension plan values by researchers and the media leads to: Significant underestimation of the magnitude of executive compensation; Severe distortions in comparisons among executive pay packages; and Significant overestimation of the extent to which executive pay is linked to performance. Our analysis demonstrates the importance of requiring companies to place the value of executive pension plans on investors radar screen. We put forward disclosure rules that would require companies to make the value of such plans transparent and thus enable investors to better evaluate the magnitude, makeup, and performance-sensitivity of total executive pay.

5 Keywords: Executive compensation, executive retirement benefits, executive pensions, stealth compensation, camouflage, pay for performance. JEL Classification: D23, G32, G34, G38, J33, J44, K22, M14 Putting Executive Pensions on the Radar Screen Lucian Arye Bebchuk and Robert J. Jackson, Jr. TABLE OF CONTENTS I. 1 II. THE NON-TRANSPARENCY OF PENSION 4 III. MOTIVATING 7 A. Pfizer s $80 Million Pension 7 B. UnitedHealth Group: Making CEO Retention More 9 C. Black & Decker: The Significance of Pensions to Shareholder 10 D. Leaving So Soon? High Pensions, Brief 11 IV. THE SIGNIFICANCE OF 12 A. 13 B. Annual Pension 15 C. Costs of Retirement Benefits: Actuarial Values of Pension 16 D. Relative Significance of Pension 18 V. PENSIONS AND THE LINK BETWEEN PAY AND 23 A. Effect of Pensions on the Proportion of CEOs Salary-Like 23 B.

6 Effect of Pensions on the Proportion of CEOs Non-Equity 24 VI. POLICY 25 A. Investors Current 25 B. Making Executive Pensions 27 VII. 30 I. INTRODUCTION When Fannie Mae CEO Franklin Raines was pushed out in December 2004, he departed with a generous package of retirement benefits. Fannie Mae will pay Raines an annual pension of $ million for the rest of his life and the life of his surviving spouse. The actuarial value of this pension benefit the present value of the stream of payments Fannie Mae shareholders should expect to make over time was about $24 million. This pension value constituted a significant component of Raines s total compensation at Fannie Mae, and it substantially weakened the link between Raines s total pay and his How common are pension plans, like this one, that comprise a substantial fraction of an executive s total pay?

7 How important are such payments to a complete assessment of the executive compensation landscape? These are the questions that we investigate in this paper. Existing disclosure rules significantly complicate these seemingly straightforward questions because they do not require companies to place a monetary value on the pensions to which executives are Pay Without Performance, a recent book co-authored by Jesse Fried and one of us, suggests that firms use retirement benefits to provide executives with substantial amounts of stealth compensation compensation not transparent to shareholders that is largely decoupled from The camouflage role of retirement benefits might, in part, explain their heavy use.

8 Whatever explains the use of pension plans and other retirement benefits, assessing their magnitude and overall effects on the 1 For a detailed analysis of Raines s retirement benefits, see Lucian Bebchuk & Jesse Fried, Executive Compensation at Fannie Mae: A Case Study of Perverse Incentives, Nonperformance Pay, and Camouflage (Working Paper Jan. 2005), at 2 Although proxy rules require some disclosure of executive pension benefits, see Executive Compensation Disclosure, Securities Act Release No. 6962, 1992 Transfer Binder Fed. Sec. L. Rep. (CCH) paragraph 85,056, the rules do not require that issuers disclose the cost of these pensions to their shareholders. Because it can be difficult for investors to ascertain the value of these pension benefits from the firms limited disclosures, see infra text accompanying notes 9-12, shareholders are often unaware of the magnitude of these benefits.

9 3 LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION (2004). 1link between pay and performance is critical to obtaining a complete picture of the executive compensation landscape. Prior research has not offered a systematic picture of the value of executive pension plans. To be sure, the press has occasionally described the pension arrangements of particular executives in Recently, for example, the media has discussed the pensions that Franklin Raines and Carly Fiorina received after departing from their respective But prior research, media coverage, and existing datasets have not provided systematic evidence about the magnitude and variance of pension values and their effects on the sensitivity of executive compensation to performance in a representative sample of companies.

10 Standard datasets of executive pay generally include only those components of compensation for which a precise monetary value is disclosed in companies public filings. Estimating the value of pension benefits requires additional research and financial analysis, and standard databases therefore do not include compensation paid through pension plans. This omission would not lead to significant distortions in analysis of executive pay if (i) pension plan values were not significant relative to total executive pay or (ii) pension plan values did not vary significantly among executives. In this paper, we examine whether these assumptions are valid and, thus, whether the exclusion of pension values from 4 See, , Michael Barbaro, A King s Ransom in Retirement Benefits: GE Pays Ex-CEO Millions a Year in Pension, Perks, WASH.


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